10/27/2009 @ 1:47PM

An Economic Agenda For The GOP

For 30 years, the Republican Party dominated American political life, winning five of the seven presidential elections before 2008. But the GOP has taken its lumps of late, culminating in its loss of Congress in 2006 and the White House last November. As the party suffers not just from a leadership vacuum but also from considerable internal division, its future direction is unclear. This much, however, is certain: As America struggles to emerge from a financial crisis, any renewal of the Right will require the Republicans to rethink their approach to the economy. An agenda focused chiefly on tax cuts, as the Republicans’ has been since Ronald Reagan’s presidency, is no longer enough.

In 1980, Reagan won the election by attracting a substantial portion of Democrats with three simple ideas. First was the fight against the Soviet Union. Second, the battle against the excesses of the state: “Government is the problem, not the solution,” Reagan famously said. Third, and most relevant to this discussion, was an overarching faith in economic growth. Growth improves everyone’s well-being, lifting the underprivileged from poverty and eliminating the need for costly fiscal redistribution. With growth as the objective, a deep cut in tax rates for higher-income people was not only justifiable but necessary, because it would increase the incentive to work and thus foster productive activity.

Lower taxes became a winning political weapon for the Republican Party–all the more so, perhaps, because the cuts weren’t accompanied by painful reductions in public spending. Fiscal deficits, traditionally unacceptable to conservatives, had even become welcome to the Right, which regarded them as a way to “starve the beast.” By burdening the state with debts, the thinking went, we could reduce its ability to expand and thus the danger that it could suffocate the economy.

In 1980, when the highest marginal income-tax rate stood at 70%, this economic platform was extremely attractive, as were Reagan’s other key ideas. The country had just seen a decade of low growth and high inflation, defeat in Vietnam, the Soviet invasion of Afghanistan, and the humiliation of the American hostages in Tehran. It was ready for change. An entire generation adhered to the Republican Party, forming a majority so solid that it permitted George W. Bush to be elected president 20 years later.

The success of the Republican platform went well beyond the voting booth, of course. The war against the evil empire brought the collapse of Communism and the democratization of the Soviet Bloc countries. During the Reagan years, the battle against the state led to a negative real growth rate in nondefense public spending. Deregulation freed the economy from excessive constraints and, together with tax cuts, sparked enormous entrepreneurial and creative forces. A golden era of economic growth began in the early 80s and continued, aside from a few minor recessionary interludes, until 2007–a quarter-century of unparalleled prosperity. After the Reagan economic reforms kicked in, the United States grew by an average of 3 % each year, against Germany’s 1.9 %, France’s 2.1, and Italy’s 1.8.

Not only did this revolution allow the U.S. to outpace Europe in income and productivity; it also transformed the country from a manufacturing economy into an innovative, high-powered service economy. Today, America does not produce iPhones, but it generates the technology and the design that permit a piece of plastic to sell for $300. It does not manufacture microchips, but it creates the technology that lets some wafers of silicon sell for thousands of dollars apiece. It does not build computers, but it develops the operating systems that run them. This transformation has enabled the United States to face the competition of emerging countries from a position of strength.

Yet today the Republican brand, so successful for over two decades, has lost some of its luster. In part, it’s simply the curse of success. The war against the evil empire has been won. Taxes were substantially reduced. The battle for deregulation has achieved many of its main objectives. Deregulation was a cry of freedom that most Americans supported back when Chicago banks couldn’t open branches in southern Illinois–let alone in other states; when a truck had to obtain a permit to transport merchandise across state borders; and when a government agency decided the prices of commercial flights. But now that these restrictions are only a distant memory, the public may see further deregulation as unnecessary, or even as a cover for the financial lobby, rather than as a symbol of freedom.

In part, too, Reagan’s platform lost its appeal because the Republican Party frequently betrayed it. How can Republicans effectively campaign against big government when the size of government increased by 33% during President George W. Bush’s first term, the largest increase in federal spending since Lyndon B. Johnson? How can Republicans portray themselves as free-market paladins when Bush’s last secretary of the Treasury, Henry Paulson, orchestrated the most massive state intervention in a Western economy since François Mitterrand’s nationalization of the French banking system? The party has much to do before it regains credibility on this score.

The Republican approach has also lost traction because the situation of Americans changed. By juxtaposing his faith in the American dream to Jimmy Carter’s portrayal of American malaise, Reagan captured the hearts of traditionally Democratic blue-collar workers who believed that with hard work, every generation would enjoy greater prosperity than the previous one. But this dream has materialized only in part. Though American GDP has doubled in real terms over the last 25 years, median real income has grown by only 17%. While the richest 1% of the population has almost tripled its real income and the richest 0.01% has more than quintupled it, the bottom 10% has increased its income by only 12%. While in 1980, an average high school graduate earned 26% less than a college graduate; in 2005 this gap had grown to 38%. The blue-collar “Reagan Democrats” are among those struggling the most.

America’s transition to a service-based economy is one reason for its growing income inequality. A country specializing in manufacturing needs many high-quality (and well-paid) workers. By contrast, a service economy can succeed with a relatively small number of geniuses that design devices like the iPhone and earn millions, while less-educated workers have fewer opportunities to make a good living.

Ironically, the relatively slow increase in American workers’ wages also results, in part, from the success of the American economic model throughout the world. In the first three quarters of the 20th century, companies operating in the United States enjoyed unique advantages: a well-educated workforce that shared pro-market values and a government sensitive to the will of the people. Dictators, torn by ideological conflicts, and populated by illiterate or semi-literate people, ran much of the rest of the world. American companies dominated easily, and American workers shared in the prosperity that came from their privileged position.

Over the last 30 years, however, these values have spread around the world. Communist countries and autocracies have become democracies. Generalized education has become the rule. And much of the world has embraced basic market principles. America has succeeded in nation-building after all–not by force, but through example. The only unfortunate consequence of this otherwise happy story, which has brought greater prosperity across the globe, is that the comparative advantage of U.S.-based production has declined, and this has put downward pressure on American workers’ wage growth.

Many Americans could not help but feel disgruntled at such developments. Until recently, though, they could console themselves with the robust capital gains on their home-equity and retirement accounts. Unfortunately, the financial crisis has destroyed this comfort, too, creating significant discontent. In a survey taken in December 2008, 60% of Americans declared themselves “angry” or “very angry” about the economic situation.

This anger is affecting political decision-making. In September 2008, when Congress voted against the first version of the Paulson plan, it did so in response to the anger pervading the country. This past March, the House of Representatives approved a 90% tax on
AIG
bonuses for the same reason. And when President Obama contradicted his advisors and condemned the bonuses paid to Merrill Lynch executives, he, too, was responding to widespread anger. The question is not whether this populist pressure will have a strong influence on policy decisions, but how: Will it work to destroy, or to improve, the market system that has brought so much well-being?

If Republicans ignore popular anger, as the party establishment did last autumn, they leave a powerful and potentially disruptive force in the hands of Democrats. The majority of the Democratic establishment does not believe in the American dream, in the importance of providing incentives for economic growth, or in the market as the best mechanism to allocate available resources. The Democrats could channel popular anger into protectionism, 90% tax rates and onerous new market constraints.

In Republican hands, though, populism could become a strong force for positive change. At the beginning of the 20th century, facing similar conditions of rising income inequality and popular anger, President Theodore Roosevelt, a Republican, approved a series of fundamental reforms that turned the United States into a modern country. From creating the Food and Drug Administration to trust busting, Roosevelt used public anger to counterbalance the power of large companies (and monopolies) and create a more efficient and popular form of market capitalism.

The Republican Party today must follow a similar strategy, updated for present circumstances. It has to move from a pro-business strategy that defends the interests of existing companies to a pro-market strategy that fosters open competition and freedom of entry. While the two agendas sometimes coincide–as in the case of protecting property rights–they are often at odds. Established firms are threatened by competition and frequently use their political muscle to restrict new entries into their industry, strengthening their positions but putting their customers at a disadvantage.

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks, for instance, benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange: they can charge wider spreads that way, and they can afford to post less collateral by using their credit ratings. For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity, and collateralization–and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else.

A pro-market strategy rejects subsidies not only because they’re a waste of taxpayers’ money but also because they prop up inefficient firms, delaying the entry of new and more efficient competitors. For every “zombie” firm that survives because of government assistance, several innovative start-ups don’t get the chance to be born. Subsidies, then, hurt taxpayers twice. A genuinely pro-market party would have resisted more vigorously the Wall Street bailouts, in line with popular sentiment.

And a pro-market approach holds companies financially accountable for their mistakes–an essential policy if free markets are to produce sound decisions. A pro-market party will fight tirelessly against letting firms become so big that they cannot be allowed to fail, since such firms may take risks that ordinary companies would never dream of.

Being pro-market does not mean being heartless. For markets to work properly, inefficient firms must be allowed to fail, but their workers don’t have to suffer unduly. In fact, it’s a market imperative that they don’t: The harsher their pain, the more politically feasible it becomes to subvert the market system to alleviate that pain. In Italy, for example, where unemployment insurance does not exist, governments frequently bail out large firms, fearing televised images of massive protests and the political cost of thousands of families without financial support. (The mechanism is so automatic, in fact, that some firms hire more people once they get into trouble.)

Thus a wise pro-market party understands that any strategy is only as good as it is politically sustainable. Markets enjoy political support primarily because of the well-founded belief that they do a better job of providing goods and services than any other arrangement. This conviction often weakens during major crises like the current one. So a pro-market party should favor a robust safety net–for people, that is, not companies. Of course, this safety net should be run on market principles as much as possible. For example, unemployment insurance should retain incentives to look for work, and the health-insurance industry should be opened up to competition. But defenders of markets cannot ignore the importance of providing such security for citizens.

They also cannot ignore the nation’s growing income inequality, and the loss of confidence, among a substantial part of the population, that the future will be better than the past. Revolting against the devastating effects of technological change, early-nineteenth-century British workers destroyed mechanized looms. Modern Luddites don’t need to resort to violence: they can resist progress by supporting protectionism and regulation. And they will do so, unless they’re given a stake in the brighter future of technological progress–retraining for new jobs, sending their children to better schools, and so on.

The knee-jerk Democratic reaction is to give these poorer citizens entitlements disguised as rights: the right to a job, the right to health care, the right to appropriate a fraction of someone else’s income. The Republican response should focus on providing opportunities. Parents should have access to good schools for their kids, regardless of their financial means or where they live. The best way to deliver on that promise is through a voucher system. Students should have better access to loans to finance their education because everyone gains from a better-educated workforce. The unemployed should have access to retraining, which can also be designed through a voucher system. Health care should be available in the marketplace; the current system, in which only employers get a tax deduction for health insurance, reduces labor mobility and increases the cost of becoming unemployed.

In the end, it’s not only the Republican Party that would benefit from these policies: It’s America and the world. The United States has been the inspiration for all who believe in freedom, both political and economic. Its identity, however, is predicated upon maintaining a political consensus that supports market values. Growing income inequality, the financial crisis.. and the perceived unfairness of the market system are undermining this consensus.

Today, the Republican Party is the best candidate to carry the pro-market flag. Being in the opposition, it is less subject to the lobbying efforts of big business, which always sides with whoever is in power. The party’s current leadership vacuum and intellectual disorientation create the perfect conditions for renewal and the emergence of a new agenda. And the nation’s social tension creates a sense of urgency. Above all, the Republican Party has a moral obligation to support markets. The United States and the world are threatened by protectionism, state intervention and dirigisme. If Republicans don’t stand up for markets, who will?

Luigi Zingales is the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business and the co-author of Saving Capitalism from the Capitalists. Adapted from the Autumn issue of City Journal.